The Internal Revenue Service recently issued final regulations under section 403(b) of the Internal Revenue Code, the first comprehensive update since 1964 of the rules regulating tax-sheltered annuity (“TSA”) programs, common in nonprofit organizations and school districts.* The new regulations make TSAs much more closely resemble 401(k) plans, and dramatically alter the obligations of an employer for oversight of non-ERISA, non–employer sponsored, voluntary TSAs.

The section 403(b) regulations complete a triad of regulations covering defined contribution plans that may be funded by employee contributions. The IRS issued final regulations for governmental 457(b) plans in 2003 and revamped the 401(k) regulations in late 2004. School districts continue to be eligible to offer defined contribution plans under either 457(b) or 403(b). Tax-exempt organizations described in section 501(c)(3) may offer defined contribution plans under either section 403(b) or section 401(k). Tax-exempt organizations may also offer defined contribution plans under 457(b), but such plans may not be funded through a secure funding vehicle. Sections 401(k), 403(b), and 457(b) together provide the exclusive means for employees to make secure pre-tax retirement contributions to employer-sponsored plans.

General

In general, the new rules will force TSA programs and products to take on more of the formal trappings of qualified plans, even where the employer has not established an ERISA plan. Employers will be responsible for overseeing compliance with the Internal Revenue Code for all of the 403(b) contracts and accounts that are available to their employees in connection with issues that apply to the entire “plan.” This will be a burden on employers with programs that are not subject to ERISA. Such employers, in some cases for the first time, will have to coordinate with vendors to ensure Internal Revenue Code compliance and will have to memorialize such coordination and compliance in a written plan document. Conversely, employers that maintain 403(b) programs that are subject to ERISA will have some new tools and reasons for imposing fiduciary oversight over vendors’ offerings.

Written Plan Requirement

The final regulations take the position that all of the 403(b) annuity contracts and custodial accounts available to an employer’s employees constitute a single 403(b) program. Accordingly, the regulations require each employer that has a 403(b) program to have a written plan document that coordinates tax compliance generally and compliance with section 403(b) specifically. Thus, when multiple vendors are involved, the document will have to reflect and coordinate:

• the maximum contribution provisions of Code section 415(c);
• the maximum employee elective deferral provisions of section 402(g);
• the limits on plan loans under section 72(p);
• anti-discrimination rules, including the universal availability rule;
• whether and how employees may exchange a 403(b) product issued by one vendor for a 403(b) product issued by another vendor;
• whether 403(b) participants may transfer 403(b) assets to the plan of a new or former employer;
• hardship withdrawal administration; and
• most importantly, the allocation of responsibility for compliance with tax rules (like those described above) among appropriate parties (which may not include participants).

Department of Labor guidance issued contemporaneously with the 403(b) regulations advises that such a plan document by itself would not jeopardize a 403(b) program’s non-ERISA status, but further advises that other discretionary activities regarding TSA program administration, such as authorizing plan-to-plan transfers, processing distributions, and making determinations regarding QDROs would jeopardize such status.

Comment: Compliance with the written document rule will require a significant effort. Employers will have to gather all of the format annuity and custodial contracts available to employees and review them in order to determine how tax compliance should be coordinated among all parties. Employers that seek to avoid ERISA coverage should be especially careful to limit the document and their activities thereunder to issues regarding legal and tax compliance. Employers will also want to reassess whether to eliminate non-ERISA TSAs or convert them to ERISA TSAs, depending on the employer’s business objectives and compliance infrastructure.

Contract Exchanges

Previous IRS guidance permitted employees to exchange one 403(b) contract for another or transfer assets from one 403(b) custodial account to another, even if the new contract or account was issued by a vendor that was not otherwise part of the employer’s TSA program. The regulations give the employer responsibilities that they did not have in these cases. Consistent with the IRS’s view that the employer must act as the central compliance clearinghouse, the final regulations permit this practice to continue, but only if the employer and the new vendor agree to share certain information necessary to ensure tax compliance, such as information concerning the participant’s employment and severance from employment, and whether the participant has taken a hardship withdrawal or a loan.

Comment: The information-sharing requirement is effective January 1, 2009 for any contract received in an exchange after September 24, 2007. Thus, beginning September 24, 2007, employers should inform employees that there is no assurance that an exchange will be tax-free, since the employer and vendor may ultimately be unable to come to terms on an information-sharing agreement.

Discrimination

Employer contributions to non-governmental section 403(b) plans must satisfy the full panoply of non-discrimination rules that have long applied to other tax-qualified plans. Governmental plans must comply with Internal Revenue Code section 401(a)(17), which limits the compensation that a plan may take into account for all purposes, including for purposes of determining contributions. The limit for 2007 is $225,000. Prior to the final regulations, nongovernmental employers could comply with these nondiscrimination requirements, applicable to employer contributions and after-tax contributions, by meeting the good-faith standard provided by Notice 89-23. This safe harbor is eliminated. Employers should adjust their nondiscrimination testing procedures accordingly.

Universal Availability

If any employee is permitted to make pre-tax or Roth contributions to a 403(b) program, then all employees of the employer must be permitted to make pre-tax and Roth contributions. Exceptions to this rule include employees eligible under another TSA plan, a governmental 457(b) plan, or a 401(k) plan; non-resident aliens; and certain students and part-timers.

Comment: The IRS has changed its longstanding position that a TSA Program could comply with the universal availability rule despite excluding visiting faculty and collectively bargained employees.

Control Group Issues

Whether two 501(c) organizations or a 501(c) organization and a taxable entity are considered part of a single control group (for all purposes, not just 403(b) purposes) is based on the particular facts and circumstances. Common control is deemed to exist between a 501(c) organization and another organization if at least 80% of the directors or trustees of one organization are representatives of, or controlled by, the other organization. Otherwise, a 501(c)(3) organization may elect to be considered under common control with another 501(c)(3) organization under certain circumstances if they regularly coordinate their daily exempt activities. The permissive aggregation rules may be expanded by the IRS under certain circumstances. Organizations that are under common control as a result of the permissive aggregation rules are not necessarily considered under common control for other purposes.

Comment: Organizations that are not clearly under common control under the 80% test should consider using the permissive aggregation rules if one of the organization’s qualified plans would otherwise fail a discrimination test or a combined plan would otherwise be a multiple-employer plan.

Plan Terminations

Employers may terminate a TSA program or freeze enrollment in the TSA program under certain conditions. The right to terminate a TSA program may prove helpful for those employers that do not want to be subject to the new regulatory burdens.

Effective Dates

The new regulations are effective January 1, 2009, with delayed effective dates, in general, for plans maintained under a collective bargaining agreement and delayed effective dates for certain specific provisions of the new regulations. Most importantly, a plan that currently excludes employees covered under a collective bargaining agreement may continue that exclusion until the later of: (1) the earlier of (a) the expiration of the collective bargaining agreement or (b) July 26, 2010; or (2) January 1, 2009.

* This Update does not discuss the special 403(b) rules for church plans.

Notice: The purpose of this newsletter is to review the latest developments which are of interest to clients of Blank Rome LLP. The information contained herein is abridged from legislation, court decisions, and administrative rulings and should not be construed as legal advice or opinion, and is not a substitute for the advice of counsel.